Related Securities and Price Discovery: Evidence from NYSE-Listed Non-U.S. Stocks

Transcription

1 Related Securities and Price Discovery: Evidence from NYSE-Listed Non-U.S. Stocks Piotr Korczak a,* and Kate Phylaktis b,** a School of Economics, Finance and Management, University of Bristol, 8 Woodland Road, Bristol BS8 1TN, United Kingdom b Cass Business School, 106 Bunhill Row, London EC1Y 8TZ, United Kingdom 16 April 2010 Abstract: In this paper we analyze whether handling related securities improves a market maker s information environment and helps to incorporate new information in stock prices. Our empirical tests are focused on New York Stock Exchange specialists and the U.S. share in price discovery of 64 British and French companies cross-listed on the NYSE. We define related securities as stocks from the same country, the same region, or other foreign stocks. We find strong evidence that a higher prominence of related stocks in the specialist portfolio is associated with a higher U.S. share in price discovery of our sample firms. We interpret our findings as evidence that concentrating market makers in similar stocks reduces information asymmetries and improves the information environment as market makers can extract information relevant to a stock from order flow to related securities. To support our argument, we show that the adverse selection component of the bid-ask spread is negatively related to the prominence of other foreign stocks in the specialist portfolio. JEL Classification: G14, G15 Keywords: NYSE specialists, cross-listing, related stocks, price discovery * Tel.: , P.Korczak@bristol.ac.uk. ** Corresponding author. Tel.: , K.Phylaktis@city.ac.uk. We would like to thank two anonymous referees, Cheol Eun, Thomas Henker, Andrew Karolyi, Michael Melvin, Peter Swan, participants at the 2004 European Finance Association Meeting, the 2005 Assurant / Georgia Tech International Finance Conference, the 2005 Financial Management Association European Conference, the 2005 MICFINMA Workshop in Madrid, and seminar participants at Cass Business School, Maastricht University and University of Bristol for their helpful suggestions and comments on earlier drafts of the paper. All remaining errors are our own. Earlier versions of this paper were titled Specialist Trading and the Price Discovery Process of NYSE-Listed Non-U.S. Stocks. Electronic copy available at:

2 Related Securities and Price Discovery: Evidence from NYSE-Listed Non-U.S. Stocks Abstract: In this paper we analyze whether handling related securities improves a market maker s information environment and helps to incorporate new information in stock prices. Our empirical tests are focused on New York Stock Exchange specialists and the U.S. share in price discovery of 64 British and French companies cross-listed on the NYSE. We define related securities as stocks from the same country, the same region, or other foreign stocks. We find strong evidence that a higher prominence of related stocks in the specialist portfolio is associated with a higher U.S. share in price discovery of our sample firms. We interpret our findings as evidence that concentrating market makers in similar stocks reduces information asymmetries and improves the information environment as market makers can extract information relevant to a stock from order flow to related securities. To support our argument, we show that the adverse selection component of the bid-ask spread is negatively related to the prominence of other foreign stocks in the specialist portfolio. JEL Classification: G14, G15 Keywords: NYSE specialists, cross-listing, related stocks, price discovery 2 Electronic copy available at:

3 1. Introduction In this paper we explore how the composition of a market maker s portfolio affects pricing. We analyze whether handling related securities improves the information environment and helps to incorporate new information in prices of a stock. Towards this end we look at New York Stock Exchange specialists and price discovery of non-u.s. stocks in their portfolios, which is an ideal setting to perform our tests. First, market making in non- U.S. stocks is associated with inherent information asymmetries (Bacidore and Sofianos, 2002) and we expect any benefits from the enhanced information environment to be particularly evident for foreign stocks. And second, by focusing on NYSE specialists we can observe individuals handling well-defined small sets of securities across which they must divide their attention (Corwin and Coughenour, 2008). We estimate the relative prominence of a stock as the proportion of its dollar trading volume in the total volume of the specialist portfolio it belongs to. Our empirical tests are focused on the question of whether the prominence of other related stocks (i.e., stocks from the same country, the same region, or other foreign stocks) in a specialist portfolio affects price discovery of a non-u.s. stock occurring on the NYSE relative to the stock s home market. According to anecdotal evidence, specialist firms aim to cluster related firms with individual specialists to exploit information advantages and match firm characteristics with specialists talents (see, Anand et al., 2008). The premise is supported by theoretical models. Strobl (2001) models the trade-off between a higher information precision when trading stocks with correlated payoffs and lower competition between dealers when the stocks are clustered. He shows that both specialists and investors can benefit when related stocks are concentrated within specialists. In a similar vein, Baruch et al. (2007) develop a model to show that, when trading a set of related stocks, market makers can infer information from the observed order flow of the related stocks, and the order flow of one firm can be relevant for 3

4 pricing of other firms. Baruch et al. (2007) argue that the clustering of closely related stocks can have a direct impact on the reduction of market making costs and they provide empirical results to support the theoretical argument. Empirical studies of stock allocations confirm the tendency to cluster related stocks. Looking at the specialist firm level, Corwin (2004) finds that new stocks are allocated to firms that trade similar stocks, for example stocks in the same industry or other foreign stocks. At the individual specialist level, Anand et al. (2008) uncover that stock reassignments between specialists within a specialist firm tend to increase industrial concentration of specialist portfolios. The potential benefits of greater information production from concentrated market making need to outweigh the risks of an overload for the specialist and attention constraints when the related stocks become active at the same time because of significant industry or country-specific news (e.g., Corwin and Coughenour, 2008; Anand et al., 2008; Chakrabarty and Moulton, 2009) In this paper we employ the U.S. share in price discovery of non-u.s. stocks crosslisted on the NYSE as our measure of the quality of the information environment of NYSE specialists and the competitiveness of NYSE pricing of cross-listed stocks. Earlier studies of price discovery in international cross-listings based on both daily and intraday data find that, on average, the home market is dominant in the pricing process. 1 However, the studies uncover a substantial variation in the foreign market s contribution to price discovery across companies. For example, Eun and Sabherwal (2003) find that the U.S. share in price discovery of Canadian firms ranges from 0.2 percent to 98.2 percent. Building on the theoretical arguments on informational benefits of concentrated market making we aim to explore whether the share in price discovery increases when related stocks have a greater importance in a specialist portfolio, as measured by their dollar trading volume in relation to 4

5 the total volume of the portfolio. We define the relatedness at three levels: the group of stocks from the same country, the group of stocks from the same region and the group of all non- U.S. stocks. We expect that stocks within these three groups have some degree of similarity and hence payoff correlation. The similarities can come from shared macroeconomic fundamentals including currency movements, common institutional factors, regulations or cultural and geographical proximity. To measure the concentration and stocks prominence in a portfolio we base on the recent literature on allocation of attention in share trading (Corwin and Coughenour, 2008; Boulatov et al., 2009). The underlying concept comes from the psychology literature on limited attention and constraints in the ability to process information (e.g., Kahneman, 1973). In the context of NYSE specialists, Corwin and Coughenour (2008) and Boulatov et al. (2009) argue that specialists allocate their attention across securities in their portfolios taking into account portfolio profits and risks, and most attention goes to most active stocks. The studies provide strong evidence that the market quality for individual stocks is driven by the attention allocated to them. We use the concept of attention to measure the prominence of stocks from the same country, the same region or foreign stocks in general in a NYSE specialist s portfolio. Following the theoretical arguments in Strobl (2001) and Baruch et al. (2007), we expect informational advantages to arise when a specialist is responsible for more similar stocks and hence is able to extract information relevant to a stock from order flow to related securities. Consequently, we expect that the U.S. share in price discovery is increasing with the prominence of similar firms. Our argument is also in line with one of the policy recommendations in Bacidore and Sofianos (2002) who suggest that the information environment can be enhanced by higher concentration of foreign stocks in particular specialists. 1 See, e.g. Lieberman et al. (1999), Kim et al. (2000), and Wang et al. (2002) for evidence on daily data; and Hupperets and Menkveld (2002), Eun and Sabherwal (2003), Grammig et al. (2005a, 2005b), Pascual et al. 5

6 Our sample consists of 64 NYSE-listed British and French companies and the sample period spans January to June As of the end of 2002, the United Kingdom had the largest number of NYSE cross-listings and the largest NYSE trading value among European countries, and France followed as the second and the fourth most important one, respectively. The estimated U.S. share in price discovery in our sample ranges from 0.0 percent to 70.2 percent based on the approach proposed by Hasbrouck (1995), and from 0.0 percent to 86.4 percent based on the method proposed by Gonzalo and Granger (1995). We argue that the significant differences in NYSE pricing of our sample of cross-listed stocks are driven by differences in the information environment across NYSE specialists who make markets in our sample stocks. Based on the meaningful cross-sectional variation of our price discovery measure we run a set of cross-sectional tests to show how the U.S. share in price discovery differs with the prominence of other related stocks in the specialist portfolio. We find strong evidence that the U.S. share in price discovery is higher when a specialist handles more related stocks and that there is a larger informational advantage from handling a broader set of international securities rather than focusing on country-specific groups of firms. We interpret the finding as evidence that a specialist who is responsible for more related stocks has an informational advantage as he can extract information from order flow to a set of firms with correlated pay-offs. We support our argument by showing a negative association between the adverse selection component of the bid-ask spread and the prominence of other foreign stocks in the portfolio. Our main findings and conclusions are robust to the exclusion of stocks reassigned between specialists in our sample period, the alternative definition of prominence, and to the alternative price discovery estimation methods. Our findings contribute to the literature on dedicated market makers (e.g., Venkataraman and Waisburd, 2007) by adding to the discussion on the factors that influence (2006), Kaul and Mehrotra (2007), Menkveld et al. (2007), and Chen and Choi (2010) for intraday studies. 6

7 the choice of either concentration or diversification in assigning stocks to market makers. We complement recent studies on attention constraints in securities trading (Corwin and Coughenour, 2008; Boulatov et al., 2009; Chakrabarty and Moulton, 2009) by providing evidence on the informational benefits of concentrated market making. We suppose that the costs of attention constraints in making markets for foreign stocks are not that great as it is less likely than the foreign stocks will become unusually active all at the same, which is more likely when the stocks are clustered by industry and not by origin. We argue that, on the other hand, information production benefits from trading a clustered set of international securities are substantial. The remainder of the paper is organized as follows. The role of NYSE specialists and differences in market making in U.S. and non-u.s. stocks are outlined in Section 2. Section 3 describes data sources and the sample of U.K. and French stocks under investigation. In Section 4, we present the methodology of our analysis. First, we discuss two approaches used to calculate relative contribution to the price discovery process based on Hasbrouck (1995) and Gonzalo and Granger (1995). Then, we outline the methodology of our cross-sectional analysis and construction of our prominence measures and control variables. Section 5 presents the main empirical results and discusses various robustness checks. Section 6 summarizes and concludes the paper. 2. The Role of NYSE Specialist and Market Making in Non-U.S. Stocks Every security traded on the NYSE has a single designated specialist. 2 The specialists are responsible for maintaining a fair and orderly market in assigned securities. They facilitate price discovery and maintain liquidity by posting firm and continuous bid and ask quotes, 2 The market model based on specialists described here was in place until October 2008, covering our sample period. Under the new rules, NYSE specialists became Designated Market Makers (DMM). DMMs have no advanced look at incoming orders and hence compete as market participants but have new rights in the way they trade. 7

8 committing own capital to supply short-term liquidity in the absence of public bids and offers, and reducing stock price volatility by trading against the market trend. At times of significant information releases or extreme order imbalances, the specialist may halt trading to allow investors to react to new information. In line with the previous literature on NYSE specialists, we identify a specialist by a unique panel location on the NYSE floor. At the beginning of 2003, specialists were located in 359 panels. Individual specialists are employed by specialist firms, and in 2003 there were seven specialist firms. When a new security is listed on the NYSE, the Exchange s Allocation Committee shortlists applications from specialist firms interested in handling the security and then the listing firm chooses a specialist firm from this pool (see, Corwin (2004) for details). Specialist firms assign securities across their own individual specialists. Stocks are hardly ever relocated between specialist firms but reassignments of securities between specialists within a firm are relatively common (Anand et al., 2008; Corwin and Coughenour, 2008). There are inherent differences between making a market in non-u.s. stocks traded on the NYSE and their U.S. domestic counterparts. They result from different institutional details and differences in the flow of information related to the security. The foreign firms securities may not be fully fungible across home and U.S. markets, they may be subject to different national regulations, accounting and reporting standards, and their trading may be influenced by time zone differences between home country and the U.S., all of which can lead to differences in pricing in markets where the firm lists (Gagnon and Karolyi, 2009). Moreover, foreign stocks are usually actively traded in their home markets and U.S. traders may have limited access to information on trading there. Domowitz et al. (1998) show that the level of information linkages between markets has a direct impact on the market quality. If the markets are not fully integrated and access to information is indeed limited, greater adverse 8

9 selection increases trading costs when informed arbitrage traders exploit price differences at the expense of less informed liquidity providers. Bacidore and Sofianos (2002) provide empirical evidence of the importance of information asymmetry and adverse selection in trading behavior and liquidity provision by NYSE specialist in non-u.s. stocks. Using proprietary data, they find that specialist closing inventories for non-u.s. stocks are closer to zero than for U.S. stocks, and specialist participation and stabilization rates for non-u.s. developed market stocks are higher than those of U.S. stocks, while for non-u.s. emerging market securities they are significantly smaller. Non-U.S. stocks are also found to have larger spreads, less quoted depth and greater volatility. The authors conclude that higher trading costs reflect additional compensation demanded by the NYSE specialists to compensate for higher adverse selection risks borne in trading foreign stocks. Higher adverse selection inherent in trading non-u.s. stocks is confirmed by Bacidore et al. (2005) in a study of the sources of liquidity for non-u.s. NYSElisted stocks. They find that foreign stocks have less displayed liquidity and a similar level of non-displayed liquidity than comparable U.S. stocks. In a related study, Moulton and Wei (2009) document narrower spreads and more competitive liquidity provision for NYSE-listed European stocks when their home markets are open. The authors interpret these findings as evidence of the impact of the availability of substitutes and the improved information environment of specialist trading during the trading overlap. Bacidore and Sofianos (2002) provide a few policy recommendations which they believe could lead to a reduction in information asymmetries associated with market making in foreign stocks and hence could reduce trading costs and increase NYSE competitiveness. One of the suggestions is a stock allocation policy that encourages concentration of non-u.s. 9

10 stocks in particular specialists. 3 Bacidore and Sofianos (2002) argue that a specialist specializing in Mexican stocks, for example, will have strong incentives to develop ties with the home market including, possibly, an association with local broker-dealers (p. 157). Corwin (2004) confirms that newly listed non-u.s. stocks indeed tend to be allocated to specialist firms that already trade other foreign stocks. The benefits of the concentration go beyond the institutional links with international stock markets though. They are also related to the theoretical arguments on informational advantages of clustering similar stocks with correlated payoffs in market makers books (Strobl, 2001; Baruch et al., 2007). As shown by Baruch et al. (2007), when market makers trade closely related stocks, they can infer information not only from an asset s own order flow, but also from order flows of the other related assets. The authors build a theoretical model and provide empirical evidence which shows that the volume in the U.S. is higher for cross-listed stocks that are correlated with other stocks traded in the U.S. market, and that is explained by the lower costs of trading in these cross-listed stocks. 3. Data and Sample The data were taken from various sources. NYSE trades and quotes were downloaded from the Trade and Quote (TAQ) database. The London Stock Exchange and the Euronext Paris provided tick data on domestic trading of British and French stocks, respectively. Intraday exchange rates were obtained from Olsen. Data on the ratio of ADR and ordinary shares come from The Bank of New York web page ( and allocation of stocks across specialists is from the NYSE. The sample period spans six months from January 2003 through June 2003 and covers 122 trading days in both U.K. and French subsamples, after exclusion of public holidays in either home or U.S. market. All three stock markets (U.S., 3 Other policy recommendations include extension of NYSE trading hours, developing and strengthening linkages between the NYSE and foreign stock markets, and efforts to improve insider trading regulations across 10

11 U.K. and France) followed similar price patterns during the sample period. There was a downward drift with a local minimum of market indices about mid-march, followed by upward trend towards the end of the sample period. There seems to be no single event or day that may be particularly noteworthy over those six months. The sample includes British and French companies listed on the domestic exchange and cross-listed on the New York Stock Exchange throughout the whole six-month sample period. We exclude two companies that changed ADR ratios (British Energy and P&O Princess Cruises) since this action could have a significant impact on liquidity (see, Muscarella and Vetsuypens, 1996). Any shocks to liquidity and microstructure environment for our sample stocks could lead to a break in comparability of the relevant characteristics of the home and U.S. markets throughout the period. We also exclude ADRs representing preferred stocks, as their pricing mechanism may be substantially different from common ADRs and ordinary shares. We depart from many prior studies by not making any exclusions on the basis of trading intensity and liquidity. We investigate the price discovery process and its determinants in the breadth of the sample, not confining it to the most liquid, and hence conceivably largest companies. 4 Altogether, our sample includes 64 companies, 43 from the U.K. and 21 from France. Table 1 presents basic characteristics of the sample stocks. The market capitalization of individual firms varies from USD 196 million for France s Compagnie Generale de Geophysique to USD 146,975 million for BP. While there is no clear difference in the average size of U.K. and French sample companies and their home liquidity, U.K. stocks tend to have higher liquidity in the U.S. market, as measured by trading volume and spreads, than their French counterparts. Still, in both U.K. and French the globe. 4 Additionally, for France Telecom, we exclude the period between March 25, 2003 and April 14, 2003 which was the difference between the date of distribution of warrants to holders of ordinary shares and the date of distribution of cash proceeds from the sale of warrants to holders of ADRs. In that period, the price difference between ADRs and ordinary shares depended on the price of warrants. Similarly, for Lafarge we exclude the 11

12 subsamples liquidity in the home market is overwhelmingly larger than in the U.S. in terms of the dollar trading volume and the number of trades. The sample mean (median) dollar trading volume in the U.S. market as a percent of the total dollar trading volume in both the home and the U.S. market during the overlapping trading hours is 4.4% (2.0%). For only two stocks, BP and France s STMicroelectronics, the NYSE captures more than 20% of total trading volume. 5 The lower liquidity in the U.S. compared to the home market is also reflected in larger effective spreads which are, on average, over twice larger in the U.S. market. 6 Moreover, there are fewer quote revisions in the U.S. than in the home market but the gap is considerably smaller than the gap in the trading activity. The London Stock Exchange and the Euronext Paris are automated, electronic limit order markets, and the New York Stock Exchange operates as a hybrid system, with both a limit book and specialists acting as market makers (see, for example, Parlour and Seppi (2003) and Hendershott and Moulton (2009) for details). Figure 1 depicts trading times in the three markets. The overlap in trading hours between London and New York starts at 14:30 GMT (9:30 EST) when the U.S. market opens and lasts until 16:30 GMT (11:30 EST) when the London Stock Exchange closes. The overlap between Paris and New York starts at 14:30 GMT and ends at 16:25 GMT, when continuous trading in Paris finishes followed by the closing auction. Because daylight saving time started in Europe one week earlier than in the U.S., there was a shorter overlap (15:30-16:30 GMT for London 15:30-16:25 GMT for Paris) from March 30, 2003 to April 6, period after June 19, 2003 that was the date of distribution of rights in the local markets only. Proceeds from the sale of these local rights were distributed to the ADR holders at a later date outside our sample period. 5 Our estimates are similar to Moulton and Wei s (2009) who find in their sample of 40 U.K. stocks cross-listed on the NYSE in the whole 2003 that, on average, 4.4% of global trading occurred on the NYSE, with a range of less than 1% to 27%. The findings are consistent with findings by Halling et al. (2008), who document the widespread presence of flow-back towards the home market and a decline in foreign trading to extremely low levels. 6 Due to the skewed distribution of the spread, particularly in the home market, its mean in the full sample and the U.K subsample exceeds the mean spread in the U.S. market. The ratio of the spreads is symmetrically distributed with no outliers though. 12

13 Following the approach commonly used in previous intra-day price discovery studies, we form our price series on the basis of equally-spaced midpoints of the best bid and ask quotes. Using transaction prices instead may suffer from the problem of autocorrelation and, moreover, quotes can be updated even if there is no trading. Supporting evidence for that is reported in Table 1, where differences in the frequency of quoting between the home and the U.S. market are visibly smaller than discrepancies in the trading volume and the number of transactions. We set our interval to one minute 7, and each point in our price series represents the average of the last best bid and ask prices within the 1-minute interval. If no change of the best quotes is reported within the interval, the observation represents the last available quotes. The first 1-minute interval each day containing quotes in both markets is the initial observation for that day in our series. 8 The choice of the sampling interval is done arbitrarily with a tradeoff in mind between too many stale quotes if the interval is too narrow and dissolution of one-way causality into contemporaneous correlations when too much activity is observed within an interval at lower frequencies. 4. Methodology 4.1 Measures of Information Shares In calculating the information share of the U.S. and home markets in the price discovery process, we use both the Hasbrouck (1995) information share technique and the Gonzalo and Granger (1995) common component method. These models are the two most prevalent common factor models. They are directly related and the results of both models are primarily derived from the vector error correction model (VECM). They provide similar results if the VECM residuals are uncorrelated. In the case where there is contemporaneous 7 As a robustness check we perform the analysis on the 2, 3 and 10-minute intervals. See Section 5 for the discussion of the results. 8 The median NYSE opening delay across 7785 firm-day observations in our sample is 4 minutes. In 25 cases it is longer than 15 minutes, and in 3 cases it is longer than 30 minutes. 13

14 correlation we use Cholesky factorization, which is, however, variable order dependent. Following Hasbrouck s (1995) suggestion we use different orders and average the upper and lower information share bounds. In our paper, we use both of the above models as complementary methods. 9 We present below both estimation approaches based on Baillie et al. (2002). We expect the price of an instrument cross-listed in a foreign market, adjusted for the exchange rate, not to deviate from the price in the home market. The law of one price, which prevents any arbitrage opportunities in international cross-listings, implies a cointegrating relationship between the log home price, p 1 t, and log U.S. price, p 2 t, converted to the same currency with a cointegrating vector β = ( β β )' = ( 1, 1)' 1, 2. In our analysis, we denominate all price series in U.S. dollars and convert local U.K. and French prices using intra-day exchange rates. 10 Both models start from the estimation of the following VECM: (1) ΔP = αβ ' P 1 + A ΔP + et, t t k j= 1 where α = ( α 1 α )' is the error correction vector, P = p, p )' is a vector of log prices and, 2 j t t j ( 1t 2t e t is a zero-mean vector of serially uncorrelated innovations with covariance matrix Ω, (2) 2 σ 1 = ρσ 1σ 2 ρσ 1σ 2 σ. 2 Ω 2 The VECM has two components: the first one, αβ ' 1, represents the long-run or P t equilibrium dynamics between the two price series, and the second one, A j ΔP t k j= 1 j, shows the short-term dynamics caused by market imperfections. 9 Previous studies have used one of the two methods, e.g. Eun and Sabherwal (2003) and Kaul and Mehrotra (2007) use the Gonzalo-Granger method, while Grammig et al. (2005a, 2005b) use the Hasbrouck method. 10 The main results remain unchanged when we convert the price series to local currencies, i.e. to pounds for U.K. stocks and to euros for French stocks. 14

15 Hasbrouck (1995) transforms equation (1) into a vector moving average (VMA) in an integrated form (3) P t = ψ (1) es +ψ *( L) et, t s= 1 where ψ (L) and ψ * ( L) are matrix polynomials in the lag operator, L. Denoting ψ = ψ 1, ψ ) as the common row vector in ψ (1), equation (3) becomes ( 2 (4) P t = ιψ ( es ) +ψ *( L) et, t s= 1 where ι = ( 1, 1)' is a column vector of ones. The increment ψ et in equation (4) is considered by Hasbrouck (1995) as the component of the price change that is permanently impounded into the price and could be due to new information. He defines this component as the common efficient price common factor. If price innovations are significantly correlated across prices, Hasbrouck (1995) uses Cholesky factorization Ω = MM ' to eliminate the contemporaneous correlation, where: m11 0 (5) M =. m12 m22 If we further denote α = γ 1, γ )', which is also the Γ in Gonzalo and Granger s ( 2 (1995) model, then the information shares of the two prices are: 2 ( γ 1m11 + γ 2m12 ) (6) S1 =, and 2 2 ( γ m + γ m ) + ( γ m ) 2 ( 2m22 ) (7) S = γ ( γ m + γ m ) + ( γ m ) To get the information share of each market, the order of the prices is changed and the calculation process is repeated. The average of the two results is suggested by Hasbrouck to be the final information share

16 Gonzalo and Granger (1995) define the common factor to be a combination of the variables P t, such that h t = ΓP, where Γ is the common factor coefficient vector. The t information shares of the two markets according to this model are as follows: (8) S 1 γ 1 = γ + γ 1 2, and (9) γ 2 S 2 =. γ 1 + γ 2 Thus, the Gonzalo and Granger s (1995) approach is concerned with only the error correction process, which involves only permanent as opposed to transitory shocks that result in a disequilibrium. It ignores the correlation among the two prices and measures each price s contribution to the common factor on the basis of its error term. The price which adjusts the least to the other price movements has the leading role in the price discovery process. In contrast, Hasbrouck (1995) defines price discovery in terms of the variance of the innovations to the common factor assuming that price volatility reflects the flow of information. Information share in this model is each price s relative contribution to the variance. 11 We conduct the usual procedures of unit root and cointegration tests before estimating the information share of each market. Because overnight price discovery may follow different dynamics, overnight returns and lags that reach the previous day are excluded from the estimation. Consequently, for each stock we exclude first k observations of the dependent variables each day. The lag length k is determined by the Schwarz Information Criterion (SIC). 11 According to Baillie et al. (2002) the two models complement each other and provide different views of the price discovery process between markets. On the other hand, de Jong (2002) concludes that Hasbrouck s measure is a more proper measure of the amount of information generated by each market. Harris et al. (2002) have different view and employ Granger and Gonzalo (1995) to estimate and test common factor components attributable to each market. 16

17 4.2. Cross-Sectional Analysis of the U.S. Contribution to Price Discovery The size of our sample, 64 stocks in total, enables us to run cross-sectional regressions to examine factors which affect the size of the U.S. market contribution to price discovery. Our dependent variable is the logistic transformation of the U.S. market contribution to price discovery. 12 By definition, the contribution lies between 0 and 1, and the transformed variable lies between minus infinity and plus infinity, which makes it suitable as a dependent variable in OLS regressions. We start with the following regression to analyze the association between the U.S. share in price discovery and the stock s own prominence and the prominence of other related stocks in the specialist portfolio: (10) U.S. share in price discovery i = β 0 + β 1 Own prominence i + + β 2 Prominence of related stocks less own i + ε i. Related stocks refer to stocks from the same country, European stocks or non-u.s. stocks interchangeably. To calculate the prominence variables we base on approaches in Corwin and Coughenour (2008) and Boulatov et al. (2009). First, we collect all daily NYSE specialist directory files for our sample period. The files list the specialist firm assigned to each security, as well as the trading location of the security on the NYSE floor as described by different posts and panels. There are 18 posts and various alphabetically labeled panels on each post, and the individual specialist responsible for each stock is identified by a unique post and panel. On the basis of the files we identify the post and panel location of our 64 sample stocks and for every day in our sample period we identify all other stocks traded together with the sample stocks in the same location. We call all stocks traded in the same location a specialist portfolio. Following Corwin and Coughenour (2008), in our analysis we include only common stocks and ADRs (CRSP share codes equal to 10, 11, 12, 30 or 31). 12 If S is the information share, then our dependent variable is ( S ( 1 S) ) ln. 17

18 Using TAQ trading data, for every security for every day in our sample we calculate the dollar volume in the trading overlap between New York and London and New York and Paris. We define a stock s prominence as the proportion of its dollar volume in the total volume of the specialist portfolio it belongs to. 13 All prominence variables are calculated for each sample firm for each day and then averaged over the sample period. The daily calculation allows for daily changes in the composition of a specialist portfolio due to stock reassignments between specialists, new stock listings or delistings. We further proceed with a set of regressions that control for factors found to affect the foreign market s share in price discovery of cross-listed stocks: (11) U.S. share in price discovery i = β 0 + β 1 Own prominence i + + β 2 Prominence of related stocks less own i + + β 3 U.S. / Total dollar volume i + β 4 U.S. / Home effective spread i + + β 5 Ln (Market capitalization i ) + β 6 U.K. dummy i + ε i. Eun and Sabherwal (2003) and Grammig et al. (2005b) show that the share in the price discovery process is directly related to the share in total trading volume and inversely related to the ratio of bid-ask spreads. 14 A higher share in total trading is likely to increase efficiency of the market and may indicate informativeness of the underlying demand (Stickel and Verrecchia, 1994). As suggested by Foerster and Karolyi (1998), it may also reflect higher competition for order flow by the foreign market, which might make the local market more responsive to the foreign market prices. For each stock, we calculate the dollar trading volume in the U.S. as a percentage of the total home and U.S. dollar volume within the trading overlap for each day in the sample period, and then the daily observations are averaged over the sample period. The bid-ask spread represents a major proportion of the trading costs, and 13 As a robustness test we recalculate the prominence on the basis of the number of trades rather than the dollar volume. The results are unchanged. 14 Harris et al. (2003) make also a connection between liquidity, information and home bias in international investment. Domestic investors may be better informed and better able to monitor local firms than foreign firms. 18

19 we expect the U.S. market contribution to the price discovery process to increase when its spreads relative to domestic spreads decline. The lower the spread on the U.S. exchange, the greater the competition from the U.S. market makers and the greater the response of the local markets. On the NYSE trades often occur inside the bid-ask quotes reflecting price improvements coming from specialists or floor brokers (see, Chordia et al., 2001), therefore we look at effective spreads to capture competitiveness between markets. 15 Effective spread is calculated as twice the absolute value of the difference between the trade price and the midpoint of the prevailing bid and ask quotes at the time of the trade, divided by the quote midpoint. It is averaged across all trades for a given firm within the trading overlap each day, and then the daily observations are averaged over the sample period. We also control for the firm size measured as the logarithm of the average daily market capitalization (in millions of U.S. dollars) over the sample period. 16 Larger firms have high transparency and tend to be of greater interest to foreign investors as found by studies of cross-border stock holdings (see e.g., Kang and Stulz, 1997). We further control for the company s country of origin by including a dummy variable equal to one for British companies and to zero for French ones. This is a proxy for familiarity and for sharing the same language and cultural background, which are documented to influence stock holding and trading decisions (see, e.g., Grinblatt and Keloharju, 2001, and Chan et al., 2005). We can expect a relatively higher U.S. share in price discovery for U.K. stocks than for French stocks. Definitions of all explanatory variables used in the regressions are summarized in the Appendix. 15 The exchanges in London and Paris are electronic order markets and transactions occur at the quoted bid or ask prices. In this respect effective spread is equal to the quoted spread. 19

20 5. Empirical Results 5.1. Vector Error Correction Results and the U.S. Share in Price Discovery We perform ADF unit root tests on the levels of two log price series for each sample firm using three different test specifications, i.e. without constant, with a constant and with a constant and time trend. The test in the first specification does not reject the null hypothesis of a unit root at the 5% significance level for any of the firms. We obtain rejections at the 5% level for at least one of the two price series for 6 stocks in the test with a constant, and for 4 stocks in the test with a constant and trend. For differenced series we can reject the null of a unit root at the 1% significance level for all stocks. In the next step we test for cointegration between prices in the home and U.S. market using the Johansen s (1991) trace statistic. For all sample stocks, we can reject the null hypothesis of no cointegration. The lag structure of the VECM is determined by the SIC criterion. We started with 15 lags, and then keeping the number of observations constant, we re-estimated the model at each shorter lag. The lag length that minimizes the criterion varies from one for Compagnie Generale de Geophysique to 13 for The BOC Group, with the sample mean and median of 7 lags. Cross-sectional descriptive statistics of the estimated cointegrating vectors are presented in Panel A of Table 2. We normalize our estimates on the home market by setting β 1 equal to one. As expected, prices in the home and U.S. market move closely together, and the average estimates of the elements of the cointegrating vector are close to the β vector of the form β = ( 1, 1)' as indicated by the theory of the law of one price. We find median β 2 is equal to Divergence from the theoretical value of minus one in the case of individual stocks is conceivably caused by transaction costs bounds implying that small divergences cannot be arbitraged away. 16 Market capitalization data are taken from Datastream. 20

21 Panel B of Table 2 presents cross-sectional descriptive statistics of the estimates of the error correction vectors α from the Vector Error Correction Models given by equation (1). The error correction vectors provide information on the adjustment of each price series to the deviation from the equilibrium in the previous period, β ' 1. Either or both home share and ADR prices must respond to the deviation to prevent riskless arbitrage opportunities. For instance, if the price in the U.S. market is lower than the price in the home market (adjusted for the exchange rate), the U.S. price will increase and the home market price will decrease in the following period to restore the equilibrium. 17 Thus, the expected signs of P t H α and will be negative and positive, respectively, and their absolute values show the magnitude of the response. We find that the median adjustment coefficient for the home market prices, α 1, is compared to the median correction in the U.S. market, α 2 US α, of Looking at the significance of individual estimates (not reported in the table), α 1 has a negative sign and is significant at the 5% level for 30 out of 64 stocks. In contrast, adjustment in the U.S. market, α 2, is positive and significant at the 5% level for 63 out of 64 stocks. The results provide first evidence that new information tends to be incorporated into stock prices in the home market, while the U.S. market follows and is responsive to what is happening on the home exchange. We subsequently calculate the U.S. share in the price discovery process using both the Hasbrouck (1995) information share approach as given by equation (7) and the Gonzalo and Granger (1995) common component method as given by (9). 18 Descriptive cross-sectional statistics of the shares in the whole sample, as well as in the U.K. and French subsamples are 17 It is also possible that the home price increases and the U.S. price increases more, or the home price decreases but the U.S. price decreases less. 18 For five stocks both α 1 and α 2 are positive. In those cases the home market seems not to be affected by the divergence from equilibrium. In the following minute, the home market moves further away and the U.S. market makes up for the divergence adjusting more in absolute values. The Gonzalo-Granger method yields a negative U.S. share in price discovery then. In those cases we arbitrarily assign a 0.01% U.S. share in the price discovery to make it tractable in further steps involving logistic transformation of the variable. 21

22 presented in Panels C and D of Table 2. Looking first at Panel C which reports the results of the Gonzalo-Granger approach, we find that the mean contribution of the U.S. market in our whole sample is 20.3% with the median of 14.3%. While there is no difference in the mean contribution between U.K. and French stocks, U.K. stocks have a higher median U.S. contribution. The results for the Hasbrouck method are presented in Panel D. The mean (median) U.S. information share is 15.5% (9.0%) and there is a very small difference between the U.K. and the French stocks. As noted earlier, the Cholesky factorization of the innovation variance-covariance matrix produces results which are variable order dependent. We adopt Hasbrouck s (1995) suggestion and report the average of both extreme bounds. In our case the mean (median) lower bound for the U.S. share in price discovery is 6.4% (2.8%) when the home price comes first in the ordering and the mean (median) upper bound is 24.6% (16.2%) when the U.S. price comes first. 19 It is worth noting that the correlation between the price discovery measures calculated according to the Gonzalo-Granger method and the Hasbrouck method is Thus, similarly to earlier studies, we find a dominant role of the home market in price discovery. Our average estimates are below the U.S. share in the pricing process of crosslisted Canadian companies found by Eun and Sabherwal (2003). Their mean and median are 38.1% and 36.2%, respectively. The difference could be due to the higher economic integration between Canada and U.S. and to the larger proportion of trading on U.S. exchanges in total trading of cross-listed Canadian stocks. However, Kaul and Mehrotra (2007), who also examined Canadian stocks, report a difference between U.S. price discovery share for cross-listed stocks in NYSE and NASDAQ. They find that the mean (median) is 13% (6%) for NYSE stocks and 47% (41%) for NASDAQ stocks. Looking at other European cross-listed stocks, our results show a larger role of the U.S. market than the results of 19 The distance between the lower and upper bound is driven by the correlation of VECM residuals. The average correlation coefficient in our estimations is

23 Grammig et al. (2005a) for German blue chips, and are of a similar magnitude to Hupperets and Menkveld (2002) findings for Dutch companies. From our perspective, the most important finding is the meaningful cross-sectional variability of the price discovery measure, in line with previous studies on different samples. We find that the estimated U.S. share in the pricing process varies from virtually zero to as high as 70.2% according to the Hasbrouck method and even 86.4% according to the Gonzalo- Granger method. Stocks with the highest U.S. share in price discovery following the Gonzalo- Granger (Hasbrouck) approach are Bunzl 86.4% (67.0%), Total 81.4% (70.2%), BP 57.9% (48.2%), HSBC Holdings 55.9% (41.5%) and AstraZeneca 55.8% (49.1%). On the other hand, the U.S. market contributes less than 2% to price discovery of Technip, Compagnie Generale de Geophysique, Scor, Veolia Environment, Publicis Groupe, Corus Group, Enodis and Premier Farnell. 20 We interpret the dispersion of the U.S. share in price discovery in our sample as evidence of differences in the information environment of NYSE specialists who are market makers for our sample stocks. In the subsequent sections we explore how the U.S. share in price discovery varies with the prominence of related stocks in the specialist portfolio which, we argue, has an impact on the informational advantage of specialists. As a robustness check we re-estimate the shares in price discovery lowering the frequency to 2, 3 and 10 minutes. 21 With lower frequencies we may reduce the number of stale quotes, but an important caveat is in order. With lower sampling frequencies crosscorrelation between price changes in the home and U.S. market increases leading to larger estimation errors in the markets share in price discovery. Contemporaneous price movements in larger windows blur the picture and make it difficult to assign the role in price discovery to individual markets. In the Hasbrouck approach, the cross-correlation results in a wider gap 20 Five of the eight stocks with the very low U.S. share in price discovery delisted from the NYSE and deregistered from the Securities and Exchange Commission (SEC) in the years following our sample period. Three of the deregistrations followed the SEC Exchange Act Rule 12h-6 (see, Doidge et al., 2008). 21 The full results are not tabulated but available from the authors upon request. 23

24 between the lower and upper bound of the information share, ultimately pushing the midpoint between the two towards the 50% mark. Indeed, the mean (median) Hasbrouck s U.S. share in price discovery increases monotonically from 15.5% (9.0%) for a 1-minute interval to 36.4% (38.4%) for a 10-minute interval. The estimates according to the Gonzalo-Granger method are more stable, and their sample mean (median) changes from 20.3% (14.3%) for a 1-minute interval to 29.0% (25.5%) for a 10-minute interval Prominence of Stocks in Specialist Portfolios This section analyzes the prominence measures of the sample stocks our main explanatory variables of interest. As defined in detail in Section 4.2, a stock s prominence is proxied by the proportion of its dollar volume in the total volume of the specialist portfolio it belongs to. We look at the prominence of our sample stocks and at the prominence of a set other similar stocks assigned to the same NYSE specialist. We define similar stocks at three levels: as stocks from the same country, the same region (in our case Europe) or other foreign stocks. The descriptive statistics of the measures for all sample stocks and for the U.K. and French subsamples are presented in Table 3. The average prominence of our sample stocks in their respective post and panel locations is 11.3%. Each stock is, on average, located with sibling stocks from the same country that generate 10.2% prominence, bringing the total prominence of all stocks from the same country to 21.5%. The average stock is also assigned to a specialist portfolio in which other European stocks capture 40.7% of the total trading volume, and in which the prominence of other non-u.s. stocks is as high as 61.7%. Our findings extend the evidence in Corwin (2004) who finds that foreign firms tend to be clustered in NYSE specialist firms. We further find that specialist firms tend to concentrate foreign stocks in individual specialists, and more than a quarter of our sample firms are assigned to panels that trade non-u.s. stocks 24